Securitization in 2015 : element of default or engine for the European economy?

Securitization in 2015: Element of

default or engine for the European

economy?

Student Supervisor

Claudia Alexandra Caluian

_{Fabiano Cavadini}

Study Degree Major

Bachelor of Science in

Business Administration

Accounting and Controlling

Project

Bachelor Thesis

Place and date of delivery

Securitization in 2015: Element of default or engine for the European economy?

Author: Claudia Alexandra Caluian Supervisor: Fabiano Cavadini

Bachelor Thesis

University of Applied Sciences and Arts of Southern Switzerland Department of Business Administration

Manno, September 2015

This paper represents author's original work and has not been submitted before to any institution for assessment purposes.

''Markets are not end in themselves, but powerful means for prosperity and security for all.''

Acknowledgement

First and foremost, I would like to express my gratitude to all professors that guided me throughout the years of study. Their patience, motivation, enthusiasm, and immense knowledge have been a source of inspiration for the person I became today.

In particular, my sincerest gratitude goes to Prof. Fabiano Cavadini, for all the support and shared enthusiasm.

I

ABSTRACT

The most recent financial crisis set in motion a re-examination of the primary forces driving the financial stability of the European Union. This paper examines the potential benefits of securitization structures considering the European economic framework. It provides an overview of the meaning, functionality, development and performance of securitization as a structured financing device, and underlines the measures undertaken by the EU after the financial crisis to restore confidence in the market while creating a sound and sustainable regulatory framework. The paper presents also a set of non-legislative initiatives and industry proposals for restating securitization in a well-functioning market. Taking the form of a review-based paper, the main objective is to pool together the set of variables that influence the European securitization market, in order to discover whether the recent changes to the framework are able to eliminate the stigma attached to securitizations after the financial crisis, and whether structured finance can resolve the financial constraints faced by European markets.

II

TABLE OF CONTENTS

1.1 Purpose of the research ... 10

1.2 Methodology and structure ... 11

2 Background research ... 13

2.1 European market charateristics ... 13

2.2 Europe: steps towards financial stability ... 16

2.3 Securitization: reasons to restore... 18

3 Understanding securitization ... 22

3.1 Definitions and features ... 22

3.2 Remarks ... 27

3.3 Securitization: before and after ... 28

4 An improved framework for European securitization ... 33

4.1 The multilateral approach ... 34

4.1.1 Markets in Financial Instruments Directive (MiFID) ... 34

4.1.2 Market Abuse Regulation ... 36

4.1.3 Banking sector ... 36

III

4.1.5 Asset management ... 41

4.1.6 Credit Rating Agencies... 43

4.1.7 Prospectus ... 44

4.2 Non-legislative Aspects ... 45

4.2.1 Criteria for simple, transparent and comparable securitizations ... 45

4.2.2 Sovereign risk and securities rating ... 47

4.3 Remarks ... 50

5 Securitization: possible contributions to financial stability. Evidence from five European countries ... 50

5.1 Demand for financing ... 51

5.1.1 Switzerland ... 51 5.1.2 EU Member States ... 52 5.2 Supply of financing ... 54 6 Conclusion ... 56 6.1 Conclusive remarks ... 56 6.2 Limitations ... 57 6.3 Further research ... 57 8 Bibliography ... 59

Annex 1 European regulatory framework and changes over time ... 61

Annex 2 Basel III - External ratings ... 67

IV

LIST OF TABLES

Table 1: European Investment Funds Initiatives ... 17

Table 2: Parties in a securitization transaction ... 22

Table 3: Rating scales ... 25

Table 4: Criteria for simple, transparent and comparable securitizations ... 47

Table 5: INCRA Rating scale ... 48

Table 6: Sovereign ratings comparison ... 49

V

LIST OF FIGURES

Figure 1: Debt financing sources for non-financial corporations ... 13

Figure 2: SME degree of recovery from 2008 to 2013, value added and employment ... 14

Figure 3: Collateral-loan required from euro area enterprises ... 15

Figure 4: European outstanding securities ratings, 2013 ... 30

Figure 5: Securities issuance 2006-2014 ... 31

Figure 6: Securities issuance; Retained and placed ... 31

Figure 7; Total European Securitization Issuance (Types of assets)... 32

Figure 8: Access to finance for SMEs ... 53

Figure 9: Investment Fund Assets by Country of Domicile at end 2012 ... 54

Figure 10: Duration of assets and liabilities of European insurance companies ... 54

VI

LIST OF ABBREVIATIONS

ABS Asset-Backed Security

ABSPP Asset-Backed Securities Purchase Programme AFME Association for Financial Markets in Europe AIF Alternative Investment Fund

AIFM Alternative Investment Fund Manager BCBS Basel Committee on Banking Supervision

BoE Bank of England

CDO Collateralized Debt Obligation

DE Germany

CH Switzerland

CRA Credit Rating Agency

CRD Capital Requirements Directive CRM Credit Risk Mitigation

CRR Capital Requirements Regulation

EAER Federal Department of Economic Affairs, Education and Research ECB European Central Bank

EFAMA European Fund and Asset Management Association EIOPA European Insurance and Occupational Pensions Authority ELTIF European Long-Term Investment Fund

ESAS European Society for Applied Superconductivity ESFS European System of Financial Supervision

VII

ESMA European Securities and Markets Authority

EU European Union

EuSEF European Social Entrepreneurship Fund EuVECA European Venture Capital Fund

HFT High Frequency Trading HQLA High-quality liquid asset

IOSCO International Organization of Securities Commissions IMA Institute for Mathematics and its Applications

IMF International Monetary Fund LCR Liquidity coverage ratio LIBOR London Interbank Offer Rate

LU Luxembourg

MBS Mortgage Backed Security MCR Minimum Capital Requirements

MiFID Markets in Financial Instruments Directive MIFIR Markets in Financial Instruments Regulation

MMF Money Market Funds

NSFR Net Stable Funding Ratio

OTC Over the Counter

OTF Organized Trading Facility OMT Outright Monetary Transaction

VIII

RO Romania

SCR Solvency Capital Requirements SME Small and Medium Enterprises S&P Standard and Poor's

SPV Special Purpose Vehicle

TFSM Task Force on Securitisation Markets

UCITS Undertakings for Collective Investment in Transferable Securities

UK United Kingdom

US United States (of America)

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1 Introduction

After many years of reforms and efforts employed to recover from the economic crisis started in 2007, Europe still presents an uneven and weak growth. While the global growth predicted for 2015 is of 3.8%, the average expected growth for Europe is 1.3%. (IMF, 2014). The effects of the crisis, in particular high level of unemployment, public debt and borrowing constraints are still the main issues addressed in the structural reforms of the European Union (EU). The uncertainty of the economic outlook creates even today a miss trust barrier that determines liquidity holders to reduce investments in the EU, which are estimated to be 15% lower than the immediate pre-crisis level. This, together with the high dependency of EU corporate sector on bank financing, not only creates an imbalance of access to credit, but holds back development and growth in the Euro area.

The various threats to the European financial stability have been difficult to identify as a consequence of the high level of interconnectedness of the modern financial system. Many markets have been affected, and placing priorities on the set of reforms to restate stability, brings Europe to face a period of transition, reflected in the disproportional recovery across the member states.

As a response to the restructuring needs of the European financial framework, in particular the need to lower the reliance on bank lending, European Commission presented in February 2015 the Green Paper ''Building a Capital Markets Union'' which aims to create a ''true single

Capital market for all European members'' (European Commission, 2015b).

Issues regarding insolvency, corporate, taxation and securities laws are addressed in order to restore confidence in the European economy and improve allocation of risk and capital. The Commission is engaging in restoring existing financial structures that have proven to be effective for the development of capital markets, starting with the securitization framework. While the stigma attached to securitization persists, reflected in the low levels of issuance since the peak prior the crisis, its capacity to stimulate loan supply cannot be ignored, as it matches the need for widening the sources of funding in the EU economy. If backed by a sound framework, securitized structures can be used to create equilibrium for loan supply and secure investments, and can help eliminate the financial constraints that are blocking growth and development in the EU member states.

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As a first step towards creation of the Capital Markets Union, restating confidence in the securitization market has a great share in restating confidence in the European financial stability, which has been very much challenged in the past years. This is why the complexity and ambiguity that characterized securitization prior the financial crisis are being addressed by targeting the primary forces participating in the evolution and expansion of this market in the first place. A prerequisite for a stable securitization framework is the stability of the main forces that combine to create the financial market, which is now translated in a series of simultaneous reforms for different financial sectors. Although there are strong reasons to impose severe regulation to the securitization framework, the desired well-functioning market requires a balance between regulatory restrictions and incentives for participation. However, results and benefits of restating the securitization market are not easily measureable across the EU member states, due to significant differences in the level of regulatory implementation and market development from one state to another.

This raises questions regarding uniformity and sufficiency, concerning the ability of new reforms to eliminate market abuse, and of continuity and sustainability of a secure framework which can change investors' current perception of securities as default products.

1.1 Purpose of the research

This research investigates the potential benefits of securitization structures considering the European economic framework. It provides an overview of the meaning, functionality, development and performance of securitization as a structured financing device, and underlines the measures undertaken by the EU after the financial crisis to restore confidence in the market, while creating a sound and sustainable regulatory framework. The significant transformation of securitization markets after the financial crisis, activated by increasing opaque and complex structures with unprecedented rates of default, caused a great adversity to securitized products. However, being prioritized by the European Authorities on the list of reforms to restate financial stability, securitization is once again subject to controversial debates. This leads to our research questions:

Can changes in regulatory framework reshape securitization in order to be considered a safe funding and risk transfer tool in the European market? Also, can securitization be the answer to the European lending constraints?

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Contrary to the specialization trend in the current academic regime, this paper follows a rather general review, aiming to bring into attention the various factors that shape the European securitization framework, both directly and indirectly.

In particular, this paper aims to:

 Provide an overview of the European economic framework;

 Recognize the benefits and implications of securitization for the European market, as well as the possible impact to the financial stability;

 Define and identify the variables that combine to make securitizations, and the path of industry development over time;

 Identify the regulatory changes to the European securitization framework;  Identify non-legislative factors of influence and relative contributions;

 Underline differences between EU member states and how securitization can address specific issues.

This paper is addressed to academics and market participants, providing an overview of considerations with the intention to form the base for further research and bespoke analysis.

1.2 Methodology and structure

The research follows a case study design, focusing on reinterpretation of existing data, both qualitative and quantitative. In presenting the European framework for securitization in 2015, a slight comparative tendency is necessary in certain sections, to better illustrate the development and drivers of the current frame of reference. Although is a review-based paper, it uses both a systematic and a narrative approach.

By using a systematic approach, the research provides a synthesis of the meaning, functionality, development and performance of securitizations, as well as a synthesis of the current regulatory framework. Reliability of information presented is given by the validity of qualitative data offered by European and international institutions. The very legislative texts, press releases, discussion papers, reports and specialized books form the base of secondary sources used for analysis. Conferences and panel discussions bring an additional source of information.

A more subjective view is given by the interpretation of results from various studies and market initiatives. With the scope of analyzing the overall effect of particular variables in the context of

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the securitization framework, the paper combines existing qualitative and quantitative data for identifying distinctions and for estimating the degree of relationship between concepts.

From a structural point of view, the obvious approach is to begin with a more general review of the European market, and then turn more specifically to the examination of the factors that combine to make the securitization market.

The chapter dedicated to the background research underlines the European market characteristics, pointing on the socio-economic-political and cultural diversity of the member states. To understand the current financial framework, a set of initiatives are presented, focusing on reforms undertaken towards restating the European financial stability. Finally, as part of this reforms, a section is dedicated to the motives behind the decision to restate the securitization market.

The following chapter provides an overview of the meaning, functionality, development and performance of securitizations. The current legal definition and the rationale behind relative transactions are being explained by presenting the parties involved and their role in the light of the characterizing features. In consideration of the role played by securitization in the last financial crisis, a series of factors have been identified as being the main shortcomings to the framework.

Taking into account the findings based on the events that triggered the financial crisis, the fourth chapter turns more specifically to the European framework. A set of factors influencing the development of a well-functioning securitization market have been determined based on the European market characteristics. Having a rather complex structure, this chapter outlines the regulatory changes - at both market and institutional level - that have an influence on the securitization framework. It then takes a non-legislative approach, indicating the contribution of other initiatives to the desired outcome.

The fifth chapter brings evidence from five European countries - Germany, United Kingdom, Luxembourg, Romania and Switzerland, analyzing the way securitization can fit in the specific financial frameworks and the possible contributions to the European financial stability.

Finally, the conclusive chapter outlines the thesis statement and author's subjective opinion on future developments.

Securitization in 2015: Element of default or engine for the European economy? 13 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

US UK Europe Japan Euro Area

Bank based Securities

2 Background research

Before entering the world of securitization and its various elements, is important to understand the characteristics of the European market and the actions undertaken by the authorities to restore the stability that has yet to be achieved, although many years have passed since the global financial shock of 2007. In spite of recognizing the role played by the infrastructure - or better, its failure to sustain the complex and interconnected market - in driving the most recent crisis, securitization remains high on the list of causes identified as main drivers of the collapse. However, the current slow economic recovery proves that structured financing is fundamental for a sustainable growth.

This chapter briefly presents the European market structure, its shortcomings and initiatives undertaken towards a more stable economic environment, and underlines the contributions a sound securitization framework can bring to the EU market.

2.1 European market charateristics

The European market is characterized by the prevalence of Small and Medium-sized Enterprises (SMEs). The last annual report (2013/2014) issued by the European Commission on SMEs' performance underlines their importance for the economic recovery after the financial crisis.

The member states of the EU present 21.2 million SMEs, which account for 99.8% of total enterprises in the non-financial business sector. They have an employment capacity of 66.8% and generate 57.9% of total value added by the non-financial business sector (Muller et al., 2014). SMEs refer to enterprises with less than 250 employees, an annual turnover of less than €50 million or having total assets of less than €43 million (Muller et al., 2014). The slow recovery from the financial crisis has been mainly caused

Figure 1: Debt financing sources for non-financial corporations

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by the lending constraints faced by the European non-financial corporations, which are highly dependent on bank financing. As underlined in Figure 1, in Europe, banks account for about four fifths of debt finance supply (IMF, 2014a).

The pressure of international regulatory bodies, in particular regulations under Basel Accords and Solvency II agreements, on bank capital adequacy, stress testing and market liquidity risk, reduced the willingness of banks to issue credit following the financial downturn. This has influenced directly the growth prospects of EU enterprises, because banks' behavior has a great impact on the liquidity level in the market, given their role as main debt financing providers.

European recovery is also influenced by the socio-economic-political and cultural diversity of the member states, which creates significant difficulties in the implementation processes of growth-driving reforms. Particularities of each member state determine different levels of inflation and interest rates, which influence the access to credit and thus the value added and employment recovery potential of each country.

Only eight member countries achieved full value added and employment recovery, while 15 countries are yet to recover their 2008 levels (Muller et al., 2014). The significant dispersion in the economic recovery of the European member states is best illustrated in Figure 2 bellow.

Figure 2: SME degree of recovery from 2008 to 2013, value added and employment

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The survey conducted by the European Central Bank (ECB) for the period 2013-2014 (ECB, 2015) regarding the access to finance of enterprises in the euro area on a sample of 11.720 enterprises, of which 91% SMEs, collected important data regarding the main concerns of individual countries. Although access to finance presents significant improvement in the last years of reforms, countries like Greece, Ireland and Netherlands still report lending constraints. This means that the positive average results are highly influenced by the unique characteristics of individual member states.

Factors considered to have most impact on the availability of external financing to euro area enterprises - the general economic outlook, firm's specific outlook and capital, the willingness of banks to lend and access to public financial support - recorded positive results under the study, but their level was again uneven across the member states.

The benefits of an increased willingness of banks to lend registered in the past years - lower interest rates and an increase in maturity loans - have favored however a limited share of EU enterprises, mainly large companies and SMEs located in the strongest economies of the EU.

The lending terms and conditions still present barriers, the most important being the high level of collateral required. Although Figure 3 does not show significant differences between the collateral level required for different enterprise sizes, this issue affects mostly SMEs, as large firms mitigate the weak credit supply through bond issuance, which has been a favorable financing method due to low interest rates. Also, access to finance through capital markets is

Figure 3: Collateral-loan required from euro area enterprises

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prevalent in strong European markets and not in the weak economies where financing problems have been most severe (ECB, 2015).

Developing a more diversified funding base results to be a prerequisite for the European growth objectives. As main drivers for job enhancement and economic growth, SMEs need an improvement of the framework in which they operate to deliver results. However, the creation of a sustainable framework cannot be achieved with a single measure, but requires the implementation of a set of reforms that take into consideration the complexity and interconnectedness of the markets.

2.2 Europe: steps towards financial stability

A lesson learned from the last financial crisis is that even the strongest economies are subject to uncertainty and volatility.

Mark Carney, Governor of the Bank of England (BoE) and Chairman of the Financial Stability Board speaks about ''real markets'' as markets that are able to resist external shocks, with well-identified accountable parties and where both public and private actors recognize their responsibilities for the system as a whole. He calls the market infrastructure a ''public good'' which should be characterized by professionalism and openness and not by informality and inaccessibility (IAHFP, 2015).

This section focuses on the key initiatives undertaken by the EU over the past period to address the threats to financial stability, and focuses on the development of the European Capital Markets Union.

The 2015 Work Programme announced by the European Commission presents new initiatives with clear objectives and concrete steps towards their achievement. The initiatives are shaped around the idea of union and around building a single, strong Global Actor. From climate change issues to migration and human rights, from trade and taxation reforms to a fairer Economic and Monetary Union, the European Commission acts upon a well-functioning legislative framework that will allow Europe to become more resistant to possible future threats.

The underlying element of all reforms and their successful implementation is, and always has been, the economic equilibrium. Relying on banks for funding their economies made European countries much more vulnerable to the events triggered by the financial collapse, and emphasized the underdeveloped state of their capital markets.

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By building the Capital Markets Union, the European Commission pursues this equilibrium, and targets few specific objectives related to the access to financing, increasing and diversifying the sources of funding and the efficiency and effectiveness of the markets. (European Commission, 2015b)

However, differences between the European member states in terms of accounting, legal and regulatory structures and especially tax systems, represent significant obstacles to the creation of a fully integrated single market for capital.

Actions have been taken to attract institutional, retail and international investors, by adopting a set of regulations to improve the European investment funds framework and to create more competition in this industry (European Commission, 2015b). The initiatives outlined in Table 1 have been undertaken to address SMEs lending constraints by matching investors' objectives with the specific needs of the borrowers.

Table 1: European Investment Funds Initiatives

UCITS (Undertakings for Collective Investment in Transferable Securities)

Is the main European framework covering collective investment schemes that are suitable for retail investors.

AIFM (Alternative Investment Fund Managers)

Covering managers of alternative investment schemes that focus on start-up companies.

EuVECA (European Venture Capital Funds)

A subcategory of alternative investment schemes that focus on start-up companies;

EuSEF (European Social Entrepreneurship Funds)

An investment scheme that focuses on all kinds of enterprises that achieve proven social impacts. ELTIF (European Long-Term

Investment Funds)

The proposed framework covering funds that focus on investing in various types of alternative asset classes such as infrastructure, small and medium sized enterprises and real assets.

MMF (Money Market Funds) The proposed European framework that covers collective investment schemes focusing on money market instruments.

Source: European Commission, 2014a

Another important source of funding is represented by the pensions and insurance sector. With the Solvency II Act entering in force in January 2016, national restrictions on the composition of the asset portfolio are being removed, enhancing long term investments.

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Other areas of focus are data aggregation, reporting, standardization of criteria and corporate governance. The actions undertaken and planned refer not only to legislative measures, but also to competition enforcement actions and infringements and country specific recommendations to the member states (European Commission, 2015a).

The weakness in the European supervisory framework have been addressed by creating a convergence program guided by European Society for Applied Superconductivity (ESAS) and European System of Financial Supervision (ESFS) in order to ensure the correct and uniform implementation of reforms along the EU member states. Also, the powers of the European Securities and Markets Authority (ESMA) and cooperation between national authorities have been enhanced.

All initiatives underlined above represent efforts undertaken to restore investors' confidence in the market and to break the barriers of miss trust set-up by the financial collapse and its effects resented in the years that followed. But the path towards maximizing the benefits of a well-integrated European Capital Market goes beyond the ability to make investors feel safe. Attracting investors also means offering products that target and meet the specific investment objectives of liquidity holders, which is equally important to their view regarding the market stability.

Although initiatives to promote crowdfunding, peer-to-peer lending and corporate bond funding have been successful, they were not able to fill the gap installed over the past years by the shrinking structured financing market. Regardless the stain left by subprime securities and market abuse, this type of structured products has the ability to create an equilibrium of loan supply and secure investments, which is exactly what European Commission is targeting by prioritizing securitization restructuring on the list of reforms.

2.3 Securitization: reasons to restore

In his speech at the IMA Public Lectures of September 21, 2010, Prof. Dr. Andrew W. Lo explains the importance of financial engineering in addressing the main concerns of the 21st century. Although he refers to issues related to lack of research funding for global concerns such as cancer and climate change, the financial stability issues around the world are equally important and are equally dependent on the same variable: the capital markets.

Prof. Dr. Andrew W. Lo underlines the limitations of the Public Sector to meet the investment needs for growth and stresses the importance of collaboration with the Private Sector. He claims that a well-functioning capital market should be able to complete the financial gap that

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holds back development and growth, and that there is no reason to delay addressing this issues, as the necessary tools to do so are already available.

The answer lies in finding the way in which the interests of market players go in the same direction; and securitization can do exactly that. He presents the securitization concept ignoring the stigma attached to it during the collapse in 2007, but focusing on its ability to meet funding needs with liquidity holders, through unique structures tailored to investor's objectives and risk preferences (IMA, 2012).

This section outlines the motive behind European reforms targeting the securitization framework, pointing on the economic rationale of financial engineering behind securitization, that cannot be invalidated by the stigma attached to it during the economic downturn.

Sound capital markets have proven their efficiency in providing the means to break the financial constraints that blocked the growth potential in the past years. The US market is a great example of economic recovery sustained by a sound capital market which allowed pressures to be contained, and to reach a growth rate of 4.2 percent in 2014 (IMF, 2014). Securitized products have a great share of total financial instruments traded in the capital markets. A return of the European securitization market for SMEs to at least half the level reached in 2007, would mean an additional €20 billion of funding available (European Commission, 2015a).

The potential benefits of securitization have been focused on its purpose: a funding tool and a risk transfer tool. Its potential to drive, or damage long-term financial stability as experienced during the last financial crisis, underlines the significant role securitization plays in building a strong capital market for Europe.

There are four main contributions that well-functioning securitization can bring to the European financial system:

1. Diversifying funding sources

The consequences of Europe's reliance on bank funding made the need for diversification of funding sources a crucial determinant for economic recovery. European investor base is dominated by the banking sector, followed by pension and insurance funds, although with a very limited share (Segoviano et al., 2015).

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Enhancing participation of non-bank institutional investors to the securitization market has the potential to widen the sources of funding for real economy, and in the same time, to support the financial stability through promoting a simpler structure with lower risk. Institutional investors can provide long-term funding, thanks to their financial structure. Securitization can provide the appropriate mean for the transfer of resources, meeting the asset-liability matching needs of investors with the long-term borrowing needs of the market (ECB and BoE, 2014). For banks, restating securitization as a safe funding tool, can free up capital for more lending, creating conditions accessible to more market players. Securitization can also mitigate asset-liability miss matching, especially through Residential Mortgage Backed Securities (RMBS), making available long-term savings rather than short-term bank deposits for financing long term housing lending.

2. Increasing the level of diversification of investors portfolios

Diversification is the core strategy of insurance companies and pension funds, which are the main buyers of long term assets. Creating a risk-return balance through direct lending can absorb many resources that can be used instead to identify other opportunities available on the market. By transforming illiquid loans into liquid ones, securitization provides the adequate product that eliminates the need for a complex due diligence infrastructure related to direct lending.

Securitization also provides for both bank and institutional investors means to mitigate risk exposure to the real economy, through the ability to diversify the risk structure of their portfolio by adopting investments in different underlying assets and different markets (ECB and BoE, 2014).

3. Risk transfer and allocation

One of the main benefits of securitization rises from the ability to create structures with different risk levels, allowing investors to create a balance in their portfolio based on their strategy.

The problem of banks dominating the credit market arises again, due to the high concentration of risk undertaken. Securitization brings the means to reduce risks on bank's balance sheet, by transferring it to the capital markets. On the one hand, banks achieve regulatory capital relief being thus able to lend more without committing too much capital. On the other hand, the process of risk transferring can be shaped to allow high degrees of protection for risk takers,

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through the bankruptcy remoteness of the SPV for cash securitizations, or through derivative structures for synthetic securitization (ECB and BoE, 2014).

This feature has been highly criticized for driving market abuse through excessive risk transfer. A first response of the Basel Committee on Banking Supervision (BCBS) was to set up standards - implemented in the EU legislation through the Capital Requirements Regulation (CRR) - that impose originating banks and sponsors to retain an economic interest of at least 5 percent of the securitized assets. Issuers, by maintaining part of the risk exposure of a portfolio, became more responsible in assessing the quality of the underlying assets, resulting in a lower overall risk undertaken for a transaction.

4. Promotes further integration of EU financial market

The European capital market continues to be highly fragmented and shaped around national borders. Breaking this limited fragmentation could lead to a lower cost of capital and improvement of resource allocation, bringing support to the growth of businesses and of economy overall.

Restoring securitization represents an important step towards the creation of the Capital Markets Union. The reforms associated with creating a simple, transparent and standardized securitization framework can help the European member states to reduce the economic differences between them, and pull the recovery of the less developed countries.

By promoting cross-border financing within the EU, member states will have the possibility to achieve their growth objectives. The financial disproportion of EU economies can slowly cease to exist as members will align towards the creation of a single Global Actor. This, together with the historical low rate of default of European securities, will also attract significant foreign investments and will strengthen the position of this products on the international markets. Similar to any other financial instrument, benefits of securitization have their costs. However, relying on past experiences, authorities have the power and the instruments to create a legal framework that can minimize risk and market abuse. The imposed risk retention is just one example of the significant measures undertaken to reduce negative conducts in the securities market. This shows that problems have been identified and addressed, and actions can be taken until a full establishment of a safe framework for securitization structures.

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3 Understanding securitization

The rationale behind restating the securitization market can be criticized for underlying the same reasons behind the expansion of this market in the first place. To understand how past structures that have been proven toxic to the financial markets can be transformed into a well-functioning market, we must first identify the pillars of securitization transactions and their development over time.

3.1 Definitions and features

Since its beginnings in 1970's, securitization was explained through various definitions that lead to the same concept: a ''carefully structured process whereby loans and other receivables

are packaged, underwritten and sold in the form of securities'' (Rosenthal & Ocampo, 1988).

Under the European framework, securitization is defined as a “transaction or scheme, whereby

the credit risk associated with an exposure or pool of exposures is tranched, having both of the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or pool of exposures; (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme”

(Allen&Overy, 2014a).

To understand this definitions and the rationale behind securitization transactions, we shall start by underlying the parties involved and their role, briefly exposed in Table 2.

Table 2: Parties in a securitization transaction

Primary Originator Represents the initial owner of the assets and the beneficiary of the proceeds resulting from the transaction.

SPV (Special purpose vehicle)

Is a legal entity where assets are transferred under a sale transaction. Is responsible for holding receivables and issuing securities.

Obligors Are the debtors who must pay the originator. The relative claims are subsequently transferred to the SPV in the securitization transaction. Investor The person or entity who purchases securities.

Trustee Supervises the transaction and holds ownership or security interest on the assets on behalf of the investors.

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paying investors. Secondary Legal and

structuring advisors

Depending on the jurisdiction, a series of advisors define the appropriate structure of the securitization transaction.

CRA Provides rating grades to the issued securities.

Credit enhancer One or more entities that provide a degree of added protection to the transaction.

Banker Can perform active roles, like placing the securities on the market, or static ones, by operating the account where the collection will be deposited.

Source: Kothari, 2006

The interaction between parties and the substance of securitization as a device of structured financing can be synthesized in three features that combine to create this financial instrument:

1. Asset-backed financing

The first element that differentiates securitization from traditional financing is the type of risk exposure. While traditional methods of financing are exposed to entity risk, securitization reduces investors' exposure only to the risks inherent in the underlying assets. (Kothari, 2006 p 12). The relationship between originator and investor is eliminated by the intermediation of the SPV. By transferring the assets to the SPV, the originator waives his claims against them, and limits the claims of investors only to the assets transferred. Some jurisdictions require approval of obligors for this transfer, but is not always the case.

The process therefore creates securities based on financial claims (receivables), breaking the traditional lending which is based on tangible assets. Securitization goes even further, by allowing not only to pool existing assets in the form of claims, but also receivables to arise in the future.

This flexibility brought the quality of collateral to the center of analysis of securitization structures. Initially, securitization transactions were backed by mortgage claims, but over time, new assets such as credit card receivables, student loans and auto loans gained popularity in their use as collaterals. The outmost feature of an asset to be considered eligible for a securitization transaction is to produce cash flows over time. This basically means that any type of receivables can qualify to form the underlying pool of assets. When constructing a pool

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of assets, other elements such as size, homogeneity and maturity composition of receivables are taken into consideration. Also, from a legal point of view, assets should be freely transferable and independent from the originator (Kothari, 2006, p 66-69).

2. Capital market financing

The overall purpose of the securitization structure is to transform illiquid assets into more liquid ones, so they become marketable. This triggers two fundamental requirements: the legal and systemic possibility of marketing the instrument and the existence of demand (Kothari, 2006, p 15).

The access to capital markets increases the ability of issuers to raise capital at lower costs and allows reaching a differentiated investor base willing and able to absorb different risk exposures. Investors on the other hand, can diversify their portfolio with a wide range of assets, facilitating risk management by matching assets and liabilities.

3. Structured finance

In a securitization transaction, risk is transferred through the issuance of different tranches of securities that allow investors to take different risk exposures in a portfolio. Tranches are structured based on priorities: the senior tranche is the last to absorb losses, followed by one or more mezzanine tranches until the junior tranche, which absorbs first loss risk. This structure allows the creation of securities tailored to investors' risk appetite, maturity and yield expectations.

The structure is sometimes used by originators as a method of credit enhancement, through the purchase of the junior tranche, taking therefore the first risk exposure of the portfolio. In fact, the structure itself provides a degree of added protection to the transaction, as each tranche is backed by the subordinated ones. Credit enhancement can also be provided by third parties, the most common being bank guarantees and insurances. Specific characteristics of the underlying assets may require different types of credit enhancement, which ultimately serve to achieve desired ratings for the issued securities (Kothari, 2006, p 210).

Ratings are used by issuers to prove the quality of a security, mostly to enhance its marketability. Generally, the CRAs offer advice on structuring and credit enhancement requirements, which can be considered a conflict of interest, as the grade is the result of a target. Ratings range from AAA (minimum risk exposure) to D (highly risky). The three global

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players that dominate the industry set-up the rating scale outlined in table xxx, creating a mean of comparison for the quality of financial instruments. Ratings serve as a benchmark for investors' decisions and have been considered for a long time an alternative for due diligence. A particularity for securitized products is the ability to have a higher rating than ratings attributed to both issuer and the underlying assets. On the one hand, this is possible due to asset isolation - held by the SPV - and on the other hand, due to the credit enhancement, which provides additional protection for investors. A security can therefore receive maximum grading if the right variables are accordingly placed. As a result, funding through securitized structures became the first choice for lower-graded issuers who could benefit a more favorable cost of borrowing compared to traditional funding which based interest rates on entity risk.

Table 3: Rating Scales

Source: Kothari, 2006

The element behind securitization transactions that makes possible the combination of the three features is the SPV - or better, the bankruptcy remoteness of the SPV. Its first and outmost role is to isolate the assets from the originator, so any disruption in activity or bankruptcy against the initial holder could not affect investors' returns and interests in the underlying assets. This is why SPVs - generally organized as single purpose companies, trusts, limited partnership or other forms, depending on jurisdiction - do not have profits, losses, liabilities or net worth (Kothari, 2006, p 636). The bankruptcy remoteness requires certain conditions to be met to ensure that (a) it cannot be consolidated with the originator, and (b) investors in the issued securities are the only ones with claims on the underlying assets. Under this conditions a SPV:

(a) Should be set-up as a single purpose entity which cannot engage in any activity other than holding and maintaining interest in the securitized portfolios;

(b) Should not have employees and cannot have fiduciary responsibilities to third parties; (c) A non-petition agreement should be signed with any person who contracts with the SPV so it cannot be taken to court for bankruptcy;

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(d) Present and future liabilities should be quantifiable and the SPV must show the capability to meet them (Kothari, 2006, p 71).

Although the guarantee provided by the bankruptcy remoteness of the SPV has been an important feature for the development of securities markets, in time, different types of structures have emerged to better meet both issuers' and investors' needs, which not always include the existence of a SPV. The two main structural forms refer to the scope of transaction. Cash structures are the traditional structures where originators sell a pool of assets to a SPV to raise cash through the issue of securities. On the other hand, Synthetic

structures do not involve the actual asset sale transaction, instead is a risk/reward transfer by

entering into a derivative transaction (Kothari, 2006, p 75).

Cash transactions have different features based on the existence of a true sale, type of payment to investors and number of pools of assets under management of a SPV. This differences are underlined below (Kothari, 2006, p 76-78):

1. True sale structure vs. Secure loan structure

True sale structures include the existence of a SPV where assets are transferred and in turn securities are issued to fund the transfer. Under a secure loan structure, cash is generated through a normal secured lending. No pool of assets is created or transferred, instead the originator is creating a fixed and floating charge over all his assets in favor of a security trustee. Although assets are general, the trustee has the right to take possession of the underlying claim in case of bankruptcy of the originator.

2. Pass-through structure vs. Collateral structure

Under pass-through structures the SPV acts as a distribution device for the interest and cash flows generated by a pool of assets to which investors hold a participation. The collateral structure, known also as pay-through structure, widens the role of the SPV, who makes reinvestments to manage the mismatch between maturities of the underlying tool and the time pattern of payments investors expect. This way, unscheduled cash flow, possible under pass-through structures can be mitigated.

3. Discrete trust structure vs. Master trust structure

A discrete trust refers to a structure in which one SPV holds only one pool of assets and investors' risk and return can be more easily identified. A master trust structure involves a

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large fund of assets that can change over time, and based on which securities can be issued in different time frames. Investors are generally attracted by this type of structure because at any time the trust holds more assets than the amount of securities issued, and they can benefit from diversification and payment according to the contractual pattern.

4. Revolving structure

Short-term assets such as credit card receivables or trade receivables are difficult to package and sell, as investors seek investments for a reasonable period. A SPV operating under a revolving structure is able to create a pool of short-term assets where the ones reaching maturity are replaced on continuous basis until the targeted amortization period (Kothari, 2006, p 91). Again, the payment pattern of obligors is managed so it cannot affect payments to investors.

3.2 Remarks

The brief description in the previous section underlines the main variables that led to the economic significance of securitization. Lending, investing and risk transferring became more accessible to financial and non-financial entities, and this was a revolutionary transformation for the financial markets and for the economies in terms of development and growth.

Highly flexible, securitization structures allow a more effective connection between liquidity holders and borrowers, stimulating the flow of credit and creating an equilibrium for the use of resources. Flexibility in financial innovation however, generates also a new set of risks, to which markets are not always ready to respond. Individual risk factors such as duration,

prepayment risk, collateral fungibility and track record of credit performance (Segoviano et al.,

2015) differ from structure to structure, and the lack of standardization increases the risk impact for investors, but also for the entire market.

For the purpose of this paper, specific risks are not treated in detail, however is important to note that the attractive features of securitized products led to an increasing number of investors seeking high yields, which in turn, generated a high pressure on the supply side to produce this assets. As a result, the structuring process became less determined by risk drivers, this having clear consequences on the industry practices, fueled also by a low regulated environment.

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3.3 Securitization: before and after

''Left unattended, [ markets] are prone to instability, excess and abuse.''

Mark Carney Securitization, in the sense that is understood today, emerged with the US mortgage-backed securities (MBS) in the early 1970's, supported by government-guaranteed entities. By 1980's, US already developed the consumer asset-backed securities (ABS) market, while Europe just started its first RMBS issuance in the United Kingdom (Segoviano et al., 2013). Volumes have increased year by year, and the market saw significant changes in the composition of the industry over time. Private-label1 securitization emerged as a response to the growing number of different types of investment funds in search for high-yield, safe-rated and fixed-income investments.

The increasing demand set off misaligned incentives along the intermediation chain, which became focused on their fee income rather than the quality of securities issued, causing a deterioration of due diligence practices and a growing number of complex structures. Creation of claims became part of the securitization process. Mortgage loans for example, were offered special features such as optional adjustability, negative amortization and interest-only payment. This practice was later called the ''originate to distribute'' model. As the quality of collateral declined and structures became more complex, the market started experiencing increasing default rates.

Fast-forward to the point of collapse, triggered by the US mortgage market - which in just five years brought subprime backed securities to a level as high as 20.1% from total mortgage issuance (Kiff et al., 2009) - the market experienced a drastic collapse in volumes, and existing securities faced significant downgrades. Global private-label securitization, which account for the most complex and opaque structures, went from a market of $5 trillion in 2006, to almost a complete exit from the US market, the leader in this sector. The US private securitization represented 56% of total issuance (Kliff et al., 2009) and its default required government intervention to maintain a certain level of stability in the market.

1

Private-label securitization products comprise those not issued or backed by governments and their agencies.

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The International Monetary Fund (IMF) specialists defines securitization of the period 2000-2007 as a ''self-reinforcing credit intermediation cycle, where a number of individual factors

had a great impact on the formation of systemic risk, by facilitating excessive risk taking concentrated across the financial sector.'' (Segoviano et al., 2013). The concentration of risk in

the banking sector, which at the end of 2006 amounted 51% of total risk exposure to the subprime market (Kiff et al., 2009, cited IMF, 2008) started the chain of downgrading economies world-wide.

The major role of securitization in the last financial crisis and the adversity faced afterwards can be attributed to five main components (Kiff et al., 2009; Segoviano et al., 2013):

1. Flawed prudential regulation - which was focused on credit, liquidity and counterparty risk

and ignored the interconnectedness between the intermediation chains;

2. Lack of transparency and asymmetry of information - risk exposures were easily hidden

from investors and regulators as accounting standards and supervisory measures did not develop at the same peace with securitization transactions.

3. The ''originate to distribute'' model - poor loan origination standards emerged as issuers

were able to transfer the risks to third parties. Because they had no ''skin in the game'', they were not interested in the actual quality of the assets securitized, but rather on the ability to generate profits from high volumes of issuance.

4. Complex securitization structures - for example re-securitizations of ABS into collateral debt

obligations (CDOs), and of CDOs into CDO-squares, as well as synthetic securitizations, created structures with so many layers that investors were hardly able to identify the risks and composition of the underlying assets.

5. Heavy reliance on CRAs - the active role played by CRAs in the securitization process by

giving advice on the structure and level of credit enhancement to reach desired ratings, created the so called trend of ''rating shopping'', based on which the issuers would choose to make public only the highest ratings offered by one of the CRAs. This created the issue of conflict of interest and raised questions on the methodologies used for risk assessment. However, the increasing complexity of securities forced investors to outsource due diligence to the CRAs, which over time became indispensible to the financial markets. Further details on the market strength of the CRAs are discussed in a later chapter.

Securitization in 2015: Element of default or engine for the European economy? 30 0 5 10 15 20 25 30 35 40 45 All Placed Retained

An issue of particular relevance regarding the ratings produced by CRAs is the fast downgrading experienced during the financial collapse. Studies show that ''of all the ABS CDO

tranches issued from 2005 to 2007 that were originally rated AAA, only 10 percent are still rated AAA by Standard & Poor’s, and almost 60 percent are rated single-B or less, well below the BBB-investment-grade'' (Kiff et al., 2009). Even though downgrading did not reach the low

levels of ABS CDOs for all securitizations, this trend covered most of outstanding securities of that period.

In spite of the market abuse of securitization structures, it would be unfair to treat the entire market as a single asset class. The performance of securitized assets varied significantly based on the type of underlying asset, market segment and maturity. (Segoviano et al., cited BIS, 2011). Taking for example European RMBS, which over the period between 2000 and 2014 had a loss of 0.2%, the performance was much higher than US RMBS which registered a loss of 7.9% over the same period (European Commission, 2015a). Characterized by a less complex structure and limited ''originate to distribute'' issuances, European securities managed to be superior to most sovereign debt, bank debt and many covered bonds and they continued to be mostly investment grade as shown in Figure 4.

In spite of the weak performance, the US securitization market saw a relatively fast recovery compared to the European market (Figure 5). One of the most important drivers was the government intervention, which covers almost 80% of the current outstanding securities. Incentives have been also created through regulatory intervention, by setting lower capital charges for banks investing in these instruments (European Commission, 2015a). Also, by fact that the US capital market is five times bigger than in Europe, we can deduce that losses have

Source: IMF, 2013

Securitization in 2015: Element of default or engine for the European economy? 31 0 100 200 300 400 500 600 700 800 900 2006 2007 2008 2009 2010 2011 2012 2013 2014 Retained Placed 0 500 1000 1500 2000 2500 3000 EU US

been distributed more evenly between banks and the capital market. However, there is no empirical evidence in this research to sustain this point of view.

This strategy of recovery was less valid for the European market. First, due to the crucial role played by banks, as main securities holders and issuers, and main financing source for the economies. Second, due to the underdeveloped capital markets across the member states. Even if European securities have had a much lower rate of default, banks' exposure to US subprime securities, together with new imposed regulation on higher capital requirements and risk retention, gave rise to an immediate need to deleverage. As an alternative to securitized products, banks and market players focused on covered bonds, which are regarded as high quality instruments. This belief is based on the double protection provided for investors: the collateral and the

unlimited liability of the issuers. In the same time, covered bonds benefit from special regulatory frameworks in many European countries, which favored the expansion of this market (ECB, 2011). However, despite having some common characteristics with securitized products, covered bonds do not provide the risk transfer benefits and regulatory capital relief associated with securitization.

Figure 5: Securities issuance 2006-2014

Source: ECB, 2015

Figure 6: European securities issuance; Retained and Placed

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Starting with 2008, European securitization was no longer a device for diversifying funding sources and for balancing risks on investors' portfolios. Issuance was concentrated in the banking sector at levels never met before, and new securities were mainly retained and used as collateral to obtain liquidity from the ECB and BoE. Figure 6 shows improvements over the last few years in terms of placed issuance, but the market remains concentrated and dependent on the banking sector.

Moreover, registered improvement does not reflect an uniform development of the market across the EU member states. In 2013, 85% of issuance was registered in Germany, Spain, Italy, Belgium and Netherlands (IMF, 2014a).

Differences are also encountered considering the type of underlying assets. European RMBS, CDOs and SME securitizations were most affected during the crisis and they represent the primary types of issuance, followed by wholesale business securitizations (WBS) and ABS (Figure 7).

Creating a framework in which benefits of securitization structures can be preserved and transmitted to individual enterprises (which are the main drivers of growth) has never been more important. Credit constraints, faced in particular by SMEs, can be reduced and foreign investment can be enhanced throughout the EU, favoring in particular those countries that are still fighting the repercussions of the

last financial crisis.

Regulatory reforms for securitization further discussed in the next chapter aim to mitigate the potential risk to financial stability, while favoring participation by setting the grounds of a safe, sustainable and standardized market. The European share of government intervention amounts to monthly purchases in public and private sector securities of €60 billion through the

Source: Segoviano et al., 2015

Note: figures for 2014 are annualized based on data to September

Figure 7: Total European Securitization Issuance (Types of assets)

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Asset-Backed Securities Purchase Programme (ABSPP). In particular, the ECB created the

Outright Monetary Transaction (OMT) facility, under which the central bank purchases government securities issued by member states on secondary markets, having as primary objective the reduction of financial fragmentation in the Euro area (OECD, 2015).

4 An improved framework for European securitization

In the previous chapters, five major issues have been identified as main determinants for the collapse of securitization markets. Addressing this issues with specific reforms is the obvious approach towards the creation of a safe, sustainable and standardized framework. While this may be true for the US market, deterioration of the European securitizations was less determined by the abuse characterizing US securities, but rather it has been a result of the contagion effect caused by the interconnected financial markets. For this reason, the approach to restate securitization in Europe considers different factors shaped around market characteristics.

Since there are so many variables that a well-functioning European securitization market relies upon, understanding the reforms undertaken requires adopting a holistic view that pictures the interconnectedness and dependency of one variable upon another. On that account, a sound securitization framework is not dependent only on the regulatory regime of the financial market, but also relies on a series of indirect challenges which must be taken into consideration.

While information asymmetry, heavy reliance on CRAs and weak prudential regulation are issues present in the European financial framework as well, the research revealed the following aspects as being the main drivers that hold back development of a well-functioning European securitization market:

 Misalignments between national laws;

 Criteria, methodologies, definitions and requirements regarding disclosure and due diligence lack uniformity across the EU financial institutions;

 Lack of a clear reference point for securities risk evaluation;  Sovereign rating affects the rating grade of securities.

Because one variable cannot be presented without another, this chapter aims to offer an overview of the legislative and non-legislative developments that shape the future of EU